Surprise as inflation falls to 1.6%

Inflation fell to 1.6% in July as fashion stores launched summer discounts and fierce competition between supermarkets helped keep a lid on food prices for the longest stretch in a decade.

The sharper-than-expected drop in the Consumer Price Index (CPI) measure of inflation, from 1.9% in June, further dampened the likelihood of any rise in interest rates this year and saw the pound fall by a cent against both the dollar and the euro.

But there was little comfort for commuters as a separate cost-of-living measure used to set rail fare rises eased off only slightly, meaning they will see a 3.5% season ticket hike in January.

The latest CPI figures mean inflation has been below the Bank of England's 2% target for seven months in a row, the first time this has happened since 2005, and they were welcomed by Prime Minister David Cameron.

He said: "Good news that inflation is down to 1.6%. We have to stick to our long-term economic plan to ensure financial security for families."

But shadow Treasury minister Cathy Jamieson said: "While this fall in the rate of inflation is welcome, the squeeze on working people continues."

Wages are still struggling,with latest figures showing a 0.2% fall. The Bank of England recently halved its forecast for 2014 pay growth from 2.5% to 1.25%.

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The largest contribution to the fall in CPI came from clothing and footwear, where prices fell 5.7% month-on-month, or 0.2% year-on-year.

Retailers usually roll out discounts at the time of year but held firm in June amid strong demand, resulting in sharper than normal falls this time.

Food and non-alcoholic beverages fell 0.4% year-on-year, after no change in June and a 0.6% drop in May. May's decline was the first since March 2006.

The latest figures meant there had been three successive months of flat or negative food inflation, the first time this has happened since the end of 2004 when prices in the sector fell for five months in a row.

CPI was also watered down in July by spirits and wine becoming less expensive while there was upward pressure from higher prices for used cars and sea fares.

Retail Prices Index (RPI) inflation, which includes housing costs, dropped from 2.6% to 2.5% meaning rail season tickets will rise by an average of 3.5% - or RPI plus 1% - from next January. It will be lower than this year's 4.1% but still well ahead of wages.

Last week the Bank pushed back City forecasts for the timing of an interest rate rise when it made clear that it would take particular account of weak pay growth in deciding when it should do so.

The new inflation figures added to expectations that the hike is now more likely to take place next year as CPI is lower than the Bank had thought.

Markets will take further clues on the thinking of the rate-setting monetary policy committee (MPC) when minutes of its meeting this month are published tomorrow.

The MPC voted to keep rates on hold at 0.5% - where they have been held since 2009 - but there was strong speculation that some members might have called for a rise in what would be the first split vote on rates since July 2011.

Laith Khalaf, senior analyst at Hargreaves Lansdown stockbrokers, said: "As long as inflation remains benign, the central bank will also have leeway to raise interest rates slowly and gradually, when they decide the time has come to do so."

Investec's Victoria Clarke said: "We view today's data as consistent with the mood music playing at present, which is that, for now, a late-2014 increase in Bank rate appears to be off the cards."

Jeremy Cook, chief economist at currency exchange company World First, said: "For the majority of the Bank of England's monetary policy committee, this figure will come as a bit of a relief.

"No policymaker would want to be caught between the rock and the hard place of a decision between heading off an inflation number running higher and a wage picture that is seeing pay fall in both real and nominal terms."

Samuel Tombs of Capital Economics said despite the latest fall, the effect of the strong pound - which keeps down import costs - had yet to feed through fully to the shops, while the recent weakness in wages was also likely to continue to keep a lid on prices.

Mr Tombs said it might not be enough to prevent the MPC from starting to "normalise" rates soon - with experts anticipating a first hike in February.

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But he said: "We believe that a general environment of benign inflationary pressure will give the committee scope to raise them at an even more gradual pace than currently anticipated by the markets."

Capital Economics expects inflation to ease to as low as 1% by the end of the year.

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